One of the first steps to investing successfully is to determine your risk profile at the onset before building a portfolio. Investors often do this by answering a series of questionnaire that touches on their attitudes toward risk and also net assets.
The answers would then ultimately serve as a guide to asset allocation and set the risk-return parameters in a portfolio. Hence, it is a crucial step that investors need to get right at the beginning to avoid a risk mismatch in a portfolio.
But the concept of risk can be tricky terrain for investors to manoeuvre especially when psychological biases and market volatility comes into play.
Among the most common misconception that investors have is the level of risk that they are prepared to accept and actually able to take.
Understanding your Risk Profile
According to Investopedia, a risk profile is an evaluation of an individual’s willingness and ability to take risks. There are two parts to the equation here, i.e. willingness and ability to take risks. Investors often get confused between the two.
Risk tolerance is the amount of risk/degree of volatility in one’s portfolio that the investor is willing to accept or able to stomach mentally. This often varies with individuals and their own psychological makeup that forms their attitude towards risk and how they view the risk-return trade off. Adrenaline junkies and high-stake speculators comes to mind and are likely wired differently from the rest of us. As such one’s risk tolerance is commonly inbuilt, though one can be coached to gradually learn to take risks.
Whereas, risk capacity measures the amount of risk/degree of volatility in a portfolio that the investor is actually able to take without unduly jeopardising one’s financial security. Different factors like age, having a steady income and liquidity requirements are some of the determinants that affect the investor’s ability to take risks.
To illustrate these two terms, consider a retiree in his 60s who no longer has a stable income and relies on his hard-earned savings to sustain his current lifestyle. Despite modest appearances, the retiree is a punter who enjoys taking risks and is able to tolerate large swings in his portfolio to get higher returns.